From the fuel in the vehicles that we drive to heating oil that warms our homes, oil is one of the world’s most widely-used natural resources. But with historic output deals set to cut production and prices in freefall, what does the future for oil?
In this guide to oil trading, we will be covering:
- What is crude oil?
- What is it used for?
- The outlook for the oil market
- How to trade oil
- Oil trading strategies you can use
What is Crude Oil?
Crude oil, which means oil from the earth, is a fossil fuel. Crude oil is formed from a mixture of hydrocarbons that were created from the remains of animals and plants that lived hundreds of millions of years ago.
The pressure created through layers of rock and sand combined with heat eventually form what we know as today as crude oil.
Crude oil can exist in both liquid and gaseous forms in underground reservoirs, as well as in sedimentary formations and near the earth's surface in tar sands.
What is Crude Oil Used For?
Crude oil is used to create petroleum products. These fuels are made by combining crude oil and hydrocarbons contained in natural gas.
Crude oil is refined and separated into usable petroleum products, which include gasoline, heating oil, diesel fuel, jet fuel, bunker fuel, and petrochemicals. The refining process in the US generates a processing gain of approximately 7%.
For example, a 100-gallon barrel of crude oil yields approximately 107 gallons of petroleum products. The volumes of each product will change as a refinery adjusts production due to market demand and seasonality.
Crude Oil Market Overview
Crude oil is a fungible product, meaning excluding transportation, the price for a specific crude oil gravity and sulfur content should be the same in every location.
Over course, this is not always true due to supply and demand forces.
Generally, if there is an opportunity to transport crude oil from one location to another and profit from this transportation, a trade will occur. This free profit opportunity will eventually be arbitraged out of the market.
The Key Global Benchmarks
The two most actively traded global oil benchmarks are Brent Crude oil and West Texas Intermediate Crude oil. Brent is an oil that is priced in Europe, of which 65% of the world’s oil is pegged to this price.
Brent Crude refers to one or all the components of the Brent Complex, which is a physically and financially traded oil market based around the North Sea of Northwest Europe.
Brent received its name from the original oil field (Brent Oil field), that was developed in the North Sea.
Brent Crude refers to the different oils that make up the Brent oil complex, which is a physically traded oil market.
The current Brent oil blend consists of oil produced from the Brent oil field the Forties oil field Oseberg, Ekofisk, and Troll oil fields.
Brent originally received its name from the initial oil field from which it was produced. Brent is a light sweet oil, that is used to produce many different types of distillates including Gasoil and Kerosene.
West Texas Intermediate oil (WTI) is a North and South American crude oil benchmark, priced in Cushing Oklahoma in the United States.
As opposed to Brent oil, WTI can be produced in any location as long as it conforms to the specifications of the oil.
WTI is light crude oil because of its relatively low density, and its low sulfur content. WTI is refined into gasoline, as well as distillates such as heating oil and diesel fuel.
WTI crude oil is lighter and sweeter, containing less sulfur than Brent, and considerably lighter and sweeter than the Asian and Middle-eastern benchmarks Dubai or Oman.
Supply and Demand
Oil is a benchmark transportation fuel, used around the globe to facilitate commerce. Oil is refined into gasoline to fuel cars as well as diesel to facilitate the movement of trucks and trains.
Oil can be refined into residual fuel for large ships as well as light ends to make plastics and chemicals, as well as many lubricants.
Oil is refined into heating oil and gas oil to heat homes and commercial buildings. Oil is also used as a fuel to turn turbines to generate electricity.
Ahead of the COVID-19 global pandemic, global crude oil demand was expected to reach 101 million barrels a day.
In the wake of the quarantines that spread across the globe and the decline in mobility, demand is expected to fall by approximately 9 million barrels a day down to 91 million barrels a day in 2020.
Demand is generally a function of global economic growth. As economic growth expands, oil demand usually rises. As global economic growth contracts, oil demand usually declines.
Global Oil production in 2019 hit a record of 100.6 million barrels a day. Global oil supply is expected to decline sharply after OPEC+ announced a historic output deal to cut production by 9.7 million barrels a day in 2020.
Additionally, the drop in crude oil prices in March and April of 2020, saw many US drilling companies out of business.
Oil rigs that are in operation in the United States dropped to 222 active rigs down from 984 during the same period of May 2019. Production dropped from 13.1 million barrels a day to 11.4 million barrels a day.
The drop in demand was driven by the lack of transportation needs throughout the globe. The International Energy Information Administration reported that refining throughput in 2020 is forecast to fall 7.6 million barrels a day to 74.3 million barrels a day.
Global refinery intake is forecast to decline by 16 million barrels a day in 2020.
How to Trade Oil
Oil is produced, refined, stored, and transported around the globe. Oil is a commodity that's traded daily, with a focus on the two global benchmarks, Brent and WTI.
There are several ways to trade these benchmarks. You can buy and sell them physically, but this requires storage, transportation, and capital.
Most of the trading that occurs in the oil markets is through futures contracts, over the counter contracts, contracts for differences as well as exchange-traded funds.
The majority of the liquidity worldwide is via futures contracts. A futures contract is the obligation to purchase or sell crude oil at a specific location at a date in the future.
The Brent oil futures contract is actively traded on the Intercontinental Exchange (ICE). ICE also offers futures contracts on the Middle-eastern crude oil benchmark.
Dubai is the Asian benchmark for the Middle East crude oil. You can also trade several different refined oil products on ICE. This includes European and Asian Gasoil as well as jet fuel and naphtha.
The oil and refined products that are traded on ICE are both financially settled and physically delivered. A physically delivered oil contract requires that you take or make delivery at a predetermined location on a specific date.
Many of the futures contracts provide the option to exchange the financially settled instrument for a physical transaction delivered to an ICE regulated storage facility.
The oil futures contracts that track WTI trade on the Chicago Mercantile Exchange (CME). The West Texas Intermediate crude oil contract (WTI) has the highest liquidity of all the oil futures contracts.
The WTI contract that is traded on the CME is physically delivered. There is also an electronic contract that is financially settled, but the liquidity pales in comparison to the physically delivered contract.
Each WTI futures contract requires delivery of 1,000 barrels of WTI crude oil, which is equal to 42,000 gallons.
The WTI futures contract trades around the clock, 6-days a week. There are 36-consecutive delivery months followed by semi-annual contracts for a couple of years, and then annual contracts for up to 10-years.
The WTI futures contract is the benchmark for hedging future production in the United States. The CME also offers gasoline contracts, heating oil contracts, Brent oil contracts, and coal contracts.
Over the Counter Contracts
Over the counter contracts are actively traded by producers, consumers, and swap dealers. Swap dealers are generally financial institutions like banks and investment banks that lend money to energy clients.
An over-the-counter contract is a customized contract that is governed by an agreement signed by both parties.
Generally, OTC contracts, which include swaps, futures look-alikes, and options, are governed by the Internationals a Swap and Derivatives Association.
This organization sets out all the rules that are used to govern an OTC agreement.
Over-the-counter agreements are generally cleared directly between the two counterparts. This means that if one party defaults there is not a futures exchange that stands between the two parties to make sure that a default does not occur.
Another investment vehicle is the exchange-traded fund. This stock-like security will hold futures contracts that track the movement of some underlying asset.
For those who do not have a futures account, this is a way of trading futures in your stock-brokerage account.
For example, the United States Oil Fund holds WTI futures contracts. Some ETFs hold companies that are active in the energy sector.
Some have exploration and production companies, others hold only oil service companies, while some hold refiners.
Contracts for Differences
Another product that tracks the movements of crude oil is a contract for differences (CFD).
As the name states, you enter into a contract for the difference between where you purchase the contract and where you sell the contract.
You do not have to purchase the underlying instrument. One of the benefits of CFDs is leverage. Leverage allows you to use borrowed capital to increase the value of the positions you can trade.
Some brokers offer leverage on CFDs as high as 500-1. This means that you only need to post $1 to control $500 worth of crude oil.
Oil Trading Strategies
Investors can use any of these trading instruments to trade the oil markets. You can quickly gauge the supply and demand by analyzing historical inventories.
Each week, the Energy Information Administration updates inventory data, after they release their production and demand estimates.
Traders might consider looking at the trajectory of inventories to determine future price movements. As the trajectory is trending lower, prices should be rising.
As the trajectory of inventories is rising, prices should be falling.
Another strategy is to evaluate market sentiment. You can look to see what hedge funds are doing weekly by evaluating the Commitment of Traders report issued by the Commodity Futures Trading Commission.
This report shows you what Swap Dealer, Managed Money and other reportables who are trading futures have transacted.
Swap dealers reflect the positions of institutional oil producers. Swap dealers will usually buy crude oil over-the-counter swaps and sell futures to hedge their positions. The Managed Money category usually represents the position of hedge funds.
When funds are adding it's usually a bullish sign. When they are reducing long positions and adding to short positions this is a bearish signal.
When the leverage of their long or short positions gets very large relative to the opposing position (i.e. 411,472 contracts long compared to 48,749 contracts short, which is approximately 8.5 to 1), you might consider a contrarian trade.
Another type of strategy is to use technical analysis. Technical Analysis is the study of past price movements to determine future price action.
Some of the basic technical analysis tools include trend following, momentum and mean reversion. The trend-following can be accomplished by using a moving average crossover strategy.
For example, when the 10-day moving average crosses above the 50-day moving average, a short term uptrend is considered in place.
The reverse is true when the 10-day moving average crosses below the 50-day moving average.
Momentum uses the difference between two moving averages to determine if prices are accelerating and decelerating.
The moving average convergence divergence (MACD) will signal a buy signal when positive momentum is accelerating and will generate a sell signal when negative momentum is accelerating.
Mean reversion occurs when the price of crude oil moves too far too fast. The relative strength index (RSI) is an oscillator that generates an index between 1 and 100.
Leverage below 30 is considered oversold and shows that prices have declined too quickly. Readings above 70 are considered overbought as prices have moved up too quickly.
The Bottom Line
You might also consider using a combination of tools to trade the crude oil market. You can evaluate inventories, look at sentiment, and consider what these studies are telling you, relative to past price movements.
Crude oil is the most widely traded energy source. It is fungible and traded around the globe. You can trade physical crude oil, but it is more cost-effective to trade using futures contracts, ETFs, CFDs or even over the counter contracts.
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